Improving efficiency during accumulation

Recommendation 10

Introduce a formal competitive process to allocate new default fund members to MySuper products, unless a review by 2020 concludes that the Stronger Super reforms have been effective in significantly improving competition and efficiency in the superannuation system.

Description

Subject to the findings of a review of the efficiency and competitiveness of the superannuation system, Government should introduce a formal competitive process to allocate new workforce entrants to MySuper products. The competitive process could be an auction or tender. Current default fund members would also benefit as funds would not be allowed to price discriminate between their existing and new MySuper members. This competitive process would replace the industrial relations system in selecting default superannuation funds for workers.

The Productivity Commission (PC) should hold an inquiry by 2020, following the full implementation of MySuper (part of the Stronger Super reforms) to determine whether further reform would be beneficial.

Objective

Enhance efficiency in the superannuation system to improve long-term net returns to members and build trust and confidence in funds regulated by the Australian Prudential Regulation Authority (APRA).

Discussion

Problems the recommendation seeks to address

As discussed in the Interim Report, funds could lower fees without compromising returns to members.14 Fees have not fallen by as much as would be expected given the substantial increase in the scale of the superannuation system. As noted by the Super System Review, a major reason for this is the absence of strong consumer-driven competition, particularly in the default fund market.15 This reflects members’ lack of engagement and reliance on employers to choose default funds for their employees.

The Stronger Super reforms implemented in response to the Super System Review aimed to address these issues. Although it is too early to draw firm conclusions, the Inquiry has some reservations about how effective these reforms will be in generating competition and the extent to which they will improve after-fee returns for members.

In the Interim Report, the Inquiry compared the fees in Australia to those overseas. Submissions challenge the observation that operating costs and fees appear high by international standards. They argue that the different features and structures of pension systems globally make comparisons difficult. A Deloitte Access Economics report, commissioned by the Financial Services Council, argues “… fees can be driven by a number of factors, and may not be directly comparable across jurisdictions”.16 The Inquiry accepts many of these arguments and acknowledges that some unique features of the Australian system contribute to elevated costs and therefore higher fees.

Other submissions attempt to make international comparisons across funds. The Association of Superannuation Funds of Australia (ASFA) states, “In international terms, Australian defined contribution (DC) members are paying fees consistent with members of similar funds overseas”.17 Since the Australian superannuation system is several times larger than DC systems overseas, Australian funds could be expected to have lower fees after accounting for differences in features.18

A major concern of the Inquiry, shared by the Super System Review, is that the Australian system as a whole has been unable to realise the full benefits of scale. The Deloitte Access Economics report concludes, “… using international experiences as a benchmark, it appears that there may be scope for lower fees in the Australian system”.19 If fees and costs could be reduced, net returns, and ultimately retirement incomes, could be higher.

In some cases, higher costs and fees may be in the interests of members. For example, alternative asset classes, such as infrastructure and other unlisted investments, tend to be more expensive to manage, but they may also diversify risks and offer higher after-fee returns for members. Submissions support this point.20

Factors driving higher costs and fees and a lack of price-based competition in Australia include:

Demand-side issues: weak member-driven competition due to lack of member interest; complexity; lack of comparability of fees and performance; and agency and structural problems.

Market fragmentation increases costs

The fragmented nature of the Australian superannuation system has limited the extent to which superannuation fund members benefit from scale economies, notwithstanding recent fund consolidations. This contributes to higher fees and lower after-fee returns to members. Australia has 294 APRA-regulated funds, most of which have a small asset base and tend to have higher fees than larger funds (Chart 2: Fees by fund size).21,22 In June 2013, around 80 per cent of these APRA-regulated superannuation funds held only around 20 per cent of assets.23,24

Chart 2: Fees by fund size

APRA-regulated funds, as at 30 June 2013 for a $50,000 balance

Source: Rice Warner.25 Line of best fit added by Financial System Inquiry.

The substantial expansion in the scale of the superannuation system over the past decade could have been expected to significantly lower fees for fund members. The size of the average fund increased from $260 million in assets in 2004 to $3.3 billion in 2013, whereas average fees fell by 20 basis points over the same period.26,27This point was highlighted in the Interim Report but not widely addressed in second round submissions. Rice Warner estimates that system growth and scale could have reduced fees by 45 basis points.28 Two-thirds of the estimated benefits from scale and lower margins over the past decade have been offset by increases in fund costs (Figure 7: Drivers of changes in average fees between 2004 and 2013).29

Weak member-driven competition

Australia’s superannuation system is different from a traditional competitive market. Compulsory contributions, coupled with a complex system, contribute to disengaged consumers and weak member-driven competition. A high degree of fragmentation has persisted because of the lack of strong competitive pressures. This is widely recognised in submissions. ASFA explains, “In an efficient market, consumers (members) would move away from less cost efficient funds to more cost efficient funds, eventually driving merger activity. However, without engagement, the expected customer movement away from these higher cost funds will not happen, removing a potential driver of merger activity”.31

Agency and structural issues

Another factor contributing to the lack of member-driven competition is the role of employers in selecting default funds. Although the benefits from a fund’s performance fully accrue to employees, much of the costs of administering SG contributions are borne by employers. For this reason, the PC’s inquiry into default superannuation funds in modern awards found employers “… might have little incentive to invest time and effort into making choices that are in the best interests of their employees”. The PC also found that employers face high search costs, may lack information and expertise to make an appropriate choice for their employees and may choose a fund based on auxiliary benefits specific to the employer, such as low administrative requirements.32

Although employers, as agents for their employees, are generally ineffective in driving competition in the superannuation market, there are exceptions. Some large corporations tender for their default fund to obtain wholesale fee discounts for employees. ASFA notes, “Fee-based competition has always been strong in the tender processes for default funds that have been undertaken by large employers”.33 In addition, some default funds specified in awards effectively benefit from lower member acquisition costs to obtain wholesale fee discounts for employees. As a result, an individual’s employer can have a significant bearing on their retirement income.

Preliminary evidence on the effectiveness of MySuper and SuperStream reforms

The Super System Review’s recommendations aimed to address many of the issues above. MySuper was introduced as a simple, low-cost, default superannuation product. SuperStream will reduce costs by streamlining the administrative functions of superannuation funds. Other elements of the Stronger Super reforms included measures to improve fee transparency and fund governance.34 The Super System Review argued that its package of reforms could reduce fees by up to 70 basis points for the most expensive investment options in larger funds.35

The Inquiry agrees with many submissions that it is too early to draw firm conclusions about the long-term effects of these reforms on average fees and net returns to members. Funds have only been able to offer MySuper products since 1 July 2013 and many are still absorbing one-off costs of the reforms. Additionally, accrued default amounts do not need to be rolled over into MySuper products until 2017.

Preliminary evidence shows a net reduction in average MySuper fees against comparable default options of 15 basis points between 30 June 2011 and 31 March 2014.36 The fall in average fees between 2011 and 2014 reflected a reduction in asset-based fees, which were partially offset by higher fixed-dollar fees. Three of the four market segments increased fees in default products between 2011 and 2014.37

The Inquiry has some reservations about whether the legislated MySuper reforms will significantly improve the competitive dynamics and efficiency of the superannuation system and realise the full benefits of scale, as follows:

Despite some early signs of fee reductions, the fees offered on MySuper products still vary widely, with a difference of 136 basis points between the highest and lowest fees (Chart 3: Range of MySuper fees).38 Differences in asset allocation and investment strategy could account for variations in fees. However, data suggests that higher MySuper investment fees do not strongly correlate with the allocation to growth assets.39

The reduction in MySuper fees against comparable default options appears to have been largely due to the Future of Financial Advice reforms prohibiting commissions in MySuper products, rather than the introduction of MySuper. Removing these commissions is estimated to reduce fees by 25 basis points, which exceeds the estimated reduction in fees to date for default products.40 However, the reduction in MySuper fees from removing commissions will not be fully realised until all accrued default amounts are moved to MySuper products, which is required to be completed by 2017.There is a risk that some MySuper fee reductions are at the expense of member returns through changes in asset allocation and investment strategy.41 Furthermore, MySuper trustees are required to consider annually whether members are disadvantaged by the fund’s scale compared to MySuper members in other funds.42 It is questionable whether this requirement will be sufficient to drive significant fund consolidation in the absence of stronger competitive pressures.

Rationale

Government intervention in the superannuation system is warranted to improve the system’s efficiency in the accumulation phase. The system lacks traditional market forces, due in part to substantial Government intervention. Also, the outcomes of the superannuation system ultimately affect both its members and taxpayers through the level of Age Pension payments.

A more efficient system would ensure that all default fund employees, including the disengaged, receive the benefits of wholesale competition — not only employees of certain large corporations and those covered by modern awards. It would also allow individuals to retain a single account throughout their working life to avoid paying multiple fees. Finally, it would mean the majority of future scale economies would benefit members through lower fees and higher retirement incomes, rather than being eroded by higher costs.

Fees can have a significant effect on retirement incomes and the total level of superannuation savings. For example, if average fees in APRA-regulated funds were reduced by 30 basis points, this would increase total member balances and funds available for long-term investment by more than $3.5 billion per annum.44 Such a fee reduction would increase the accumulated balance at retirement for a male employee on average weekly ordinary-time earnings by around $32,000, and provide up to approximately an extra $2,000 per year in retirement income (in 2014 dollars).45

Options considered

The Interim Report raised the first option below. The second option was raised in submissions and stakeholder discussions.

Recommended: Introduce a formal competitive process to allocate new default fund members to MySuper products, unless a review by 2020 concludes that the Stronger Super reforms have significantly improved competition and efficiency in the superannuation system.

Allow employers to choose any MySuper product as the default product for their employees and/or strengthen the MySuper licensing process.

Option costs and benefits

Introduce a formal competitive process to allocate new default fund members to MySuper products, unless a review determines it is not necessary

Under this option, each fund would be required to compete for new workforce entrants to be allocated to the fund’s MySuper product, thereby building on the MySuper framework. Individuals would retain the right to exercise choice (see Recommendation 12: Choice of fund). Employers would no longer be required to select default funds for employees, and there would be generally no need to specify default funds in employment contracts, including awards.

This option would stimulate competition in the default fund market and extend the benefits of wholesale competition, which are currently only obtained by larger corporations and through awards, to the broader workforce. More of the benefits of scale would accrue to members, ensuring fee reductions do not come at the expense of lower net returns.

The benefits of this option would not be limited to new workforce entrants. As mentioned, successful funds would be required to provide the same product to their existing default members. Better outcomes in the default fund market would be expected to have flow-on effects to the non-default (or ‘choice’) market. Fees charged for default products provide a point of comparison against which more fee-sensitive consumers can assess choice products.

A number of stakeholders support a process to foster competition. National Seniors Australia recommends “… the government further investigate auctioning management rights to default super funds as a way of fostering fee competition between super funds and, subject to a satisfactory auction design, commit to implementing this approach”.46 Other stakeholders believe the current level of competition between MySuper products is reasonable.

Existing members would retain their active fund when they change employment, without having to take action. Currently, in many cases, members have to consolidate accounts or exercise choice when they change employers to remain in their fund. This option addresses the main driver of account proliferation and would reduce the extent of workers paying fees and insurance in multiple accounts or losing superannuation accounts.47 This could increase superannuation balances at retirement by around $25,000 and retirement incomes by up to $1,600 per year.48

This option would remove the role of the industrial relations system in selecting default funds. This would reduce employers’ compliance costs and address concerns, raised in several submissions, about superannuation funds offering employers inducements to choose the fund.49 It would also better align incentives between employers and employees.

A potential downside of this option is less tailoring of life insurance policies and investment strategies to specific demographics of fund members; for example, if members work in the same industry. Some superannuation funds have been able to tailor insurance and other product features because of the homogeneous nature of their membership.

It is possible that the competitive process conducted by Government could create perceptions that Government is implicitly underwriting product performance of the successful funds. Government should continue to make it clear that it does not guarantee the performance of any fund, including those selected through any competitive process.

Stakeholders raise a number of concerns with how a competitive process would be designed. The Inquiry agrees with submissions’ arguments that a competitive process would not be effective if it focused on fees alone. However, large corporates run competitive tenders and there is no evidence to suggest that these tenders in the wholesale market have either disadvantaged members or been unable to balance lower costs with asset allocation strategies that maximise returns to members. See the Implementation considerations section for a detailed discussion of potential design issues and how these could be overcome.

Superannuation system review by 2020

Funds and their members have incurred significant costs as the Stronger Super reforms have been implemented. Although the Inquiry has some reservations regarding the extent to which the reforms will increase superannuation system efficiency, it recognises the need for full implementation of MySuper to allow it the opportunity to work before embarking on further reform. The outcomes of these reforms should be reviewed after all accrued default amounts have been rolled into MySuper products in 2017, by which time MySuper products will have been in operation for at least four years. Submissions support such a review.

Allow all employers to choose any MySuper product as the default fund for their employees and/or strengthen the MySuper licensing process

The Inquiry considered two additional alternatives to the current arrangements.

The first alternative involves abolishing the new Fair Work Commission (FWC) process for selecting default funds in awards and allowing all MySuper products to be listed in awards. Under this alternative, employers could select any MySuper product to satisfy the requirements under an award.

A number of submissions support this option, arguing that present arrangements are costly to members, Government and industry, and duplicate APRA’s MySuper licensing process. Some stakeholders are also concerned that the FWC selection process lacks transparency.

The Inquiry believes that this alternative would only be effective if there were an alternative quality filter for default fund selection. The PC’s inquiry into default funds in awards found that a ‘quality filter’ is needed, stating: “The Stronger Super reforms serve largely to standardise features and promote disclosure to improve comparability between MySuper products, rather than filter out any products which may not represent the best interests of employees”.50 The PC made a number of recommendations to improve the effectiveness of this filter, which the Inquiry supports and which are still to be implemented by Government.

This option could also increase employers’ compliance costs, particularly new employers, by requiring them to select a fund from a large number of MySuper products that are not easily comparable. In its report, the PC quoted CPA Australia as saying, “To allow all MySuper products to be listed as default funds for a modern award would result in overwhelming choice making it difficult for [employers] to differentiate and make an informed choice in much the same way as if no funds were listed”.51

The second alternative involves strengthening the current requirements for MySuper products, which could be achieved by imposing stricter MySuper licensing requirements, including caps on fees. Fee caps could be effective in reducing fees, but would not necessarily improve returns net of fees and may lead to clustering of fees around caps. A stricter approach to regulating MySuper products would fundamentally change APRA’s role from authorisation to approval. It would increase the cost of the validation process for funds and risk APRA having to withdraw funds’ MySuper authorisation. This would have adverse implications for employers, who would have to choose another default product for their employees, and contribute to the proliferation of individuals with multiple accounts.

Conclusion

Introducing a formal competitive process has considerable merit and is likely to deliver substantial benefits to superannuation fund members. It would stimulate competition between funds on fees and returns to deliver better member outcomes. Although this is expected to generate further fund consolidation, the Inquiry does not have major concerns given the current high degree of fund fragmentation. The recommendation would build on the recent Stronger Super reforms and extend the benefits of wholesale competition to the broader default fund market.

Although industry would bear costs to participate in the competitive process, these costs are expected to be small relative to the benefits for members from reduced fees.

While considering the Stronger Super reforms to be a positive and significant step forward, the Inquiry has some reservations as to whether these reforms alone will significantly improve superannuation system competition and efficiency. Recognising it is too early to evaluate their effectiveness, the Inquiry recommends a review of the superannuation system by 2020 before proceeding with further reform.

Implementation considerations

Review of the superannuation system by 2020

A PC inquiry into superannuation system efficiency and competitiveness should occur by 2020, after the MySuper implementation is complete in 2017. The inquiry should consider:

The nature of competition in the superannuation default fund market, including how employers select default funds.

Changes in fees and returns net of fees and taxes (including links to scale economies, asset allocation and/or type of investing) in both accumulation and retirement products.

Design of the competitive process

Default funds for new members could be selected through a range of competitive processes, including auctions or tenders. New workforce entrants could be assigned to a MySuper product when they apply for a tax file number.

Designing a robust process will require careful thought and consultation. Without pre-empting the findings of its inquiry, the PC should begin preliminary work to design the competitive process. This work should commence from 2015 to provide the inquiry with a clear proposal against which to assess the benefits of further policy change.

In designing the competitive process, the merits of different approaches should be considered, as well as the associated metrics and frequency of running the competitive process using an evidence-based approach. This should include:

Reviewing the strengths and weaknesses of competitive processes used in large corporate tenders, used by the Northern Territory Government and in other jurisdictions, such as Chile, New Zealand and Sweden.

Quantifying the costs and benefits of different mechanisms.

Assessing the incentives embedded in the scheme to evaluate its robustness to gaming and collusion.

Best interests: ensure incentive compatibility with meeting the best interests of members, encourage long-term investing, discourage excessive risk taking and encourage a focus on after-fee returns.

Competition: drive pressure on funds to be innovative and efficient, diversify asset allocation and maximise long-term after-fee returns by rewarding best performers. Facilitate new superannuation fund entrants to the market.

Feasibility: ensure the process is low-cost and easy to administer, and minimises regulatory costs on industry.

Credibility and transparency: make relevant information public; avoid room for gaming the process; and ensure metrics are clear, simple, difficult to dispute and difficult to manipulate.

Regular assessment and accountability: regularly conduct a repeat process that requires default funds to earn their right to receive new members, and ensure funds are accountable for the outcomes they deliver members.

Criteria for selecting the successful funds should focus on expected after-fee returns based on asset allocation and investment strategy, fees and past performance. This would help avoid fee reductions at the expense of member returns. Any other requirements deemed necessary could be included as pre-selection criteria to participate in the competitive process.

The Inquiry agrees with stakeholders that the formal competitive process also needs to be carefully designed and implemented (see Table 4: Potential design issues of a competitive process).

Table 4: Potential design issues of a competitive process

Potential design issues or concerns

Response or design approach

A formal competitive process is unproven. Furthermore, governments have a poor track record of running formal competitive processes.

Large corporate funds successfully run tenders. A number of other jurisdictions use competitive tendering in pension funds; for example, New Zealand, Chile, and Sweden. Governments around Australia run successful tenders, including the Future Fund, and the Northern Territory Government for its public sector superannuation scheme.

The market disruption would be too great.

The effect on market structure could be gradual, as only new entrants to the workforce would be assigned to funds under the competitive process. By default, existing members would remain in their current fund, thereby minimising market disruption. Unsuccessful funds may have increased switching rates; however, current switching rates are very low.53 All funds can still compete for choice members.

A Chilean-style auction that selects a single or small number of successful bidders would inhibit competition and innovation, and lead to excessive market concentration.

A significant number of successful funds would be selected, which would drive competition and innovation. Some market consolidation is likely to occur, but excessive market concentration can be avoided if a sufficient number of funds are selected through the competitive process.

Fees should not be the sole focus. This would result in a ‘race to the bottom’ whereby funds change asset allocation and investment strategies to reduce fees.

The Inquiry agrees with this sentiment and considers a focus solely on fees is not in members’ best interests. As discussed above, the focus should include expected ability to generate high after-fee returns based on asset allocation and investment strategy, as well as past performance.

How will the competitive process lower fund costs?

Competitive pressures will help to keep fund costs down as assets in the system continue to grow. Member acquisition costs will fall as funds do not need to compete for default fund members (outside the tender process). More consolidation of funds and reduced proliferation of multiple accounts across members will better realise the benefits of scale.

Focusing on the default fund market and only targeting new entrants to the workforce is too narrow-focused. It will not address competition and efficiency issues in the broader superannuation system.

Successful funds would be required to offer the same fees and MySuper products to all members (both new and existing). They could not price discriminate across the market. Outcomes in the default market represent a baseline against which choice products could be compared and could be expected to drive greater competition. Transfers to these funds would be facilitated by the recommendations to allow all employees choice of fund (discussed in this chapter) and increase member engagement (see Appendix 1: Significant matters for further detail).

A competitive process would lead to the loss of existing high-performing corporate funds.

Existing corporate funds could be allowed to continue to receive new default fund members from new entrants to the workforce provided the fund gives members comparable benefits to funds successful in the formal competitive process.

Any competitive process can be gamed.

Careful design, rigorous execution and the highest standards of probity and expertise will be required. As mentioned above, other jurisdictions and corporations already run tenders successfully.

Past performance is not an accurate predictor of future performance.

Past performance would be only one element of the selection process when assessing expected ability to generate high after-fee returns to members.

Funds that do this could be disqualified from future competitive processes. Prompts on myGov for individuals to look at a central repository of MySuper dashboards would also help encourage members to engage with superannuation and transfer to the fund that best meets their needs (see Appendix 1: Significant matters for further details).

What if a successful high-performing fund underperforms?

Funds could lose the right to receive new members. Members would be advised if their fund was no longer deemed a successful fund.

A competitive process would impose costs on employers, who would have to make contributions to multiple funds.

While SuperStream will simplify how contributions are made, Government should consider implementing a national ‘payment hub’ or ‘clearing house’ by which employers make superannuation contributions to multiple funds. This concept has been implemented in other countries, including New Zealand and Sweden.

20 For example, Financial Services Council 2014, Second round submission to the Financial System Inquiry, Chapter 1, page 27; SuperRatings 2014, Second round submission to the Financial System Inquiry, page 15; Australian Institute of Superannuation Trustees 2014, Second round submission to the Financial System Inquiry, page 19; Mercer 2014, Second round submission to the Financial System Inquiry, page 25.

21 In this report, APRA-regulated funds refers to only those with more than four members.

38 Note that there are differences between the data used by Rice Warner and the MySuper data for June 2014 published by the Australian Prudential Regulation Authority (APRA). This reflects recent updates to data and differences in reporting fees between APRA’s data and product disclosure statements.

41 For example, some MySuper products have benchmark asset allocations to cash and fixed income of up to 50 per cent. Australian Prudential Regulation Authority (APRA) 2014, Quarterly MySuper Statistics, June 2014, APRA, Sydney.

44 A reduction in fees of 30 basis points corresponds to the difference between the average fee of the top quartile of MySuper products and all MySuper products. The fee reduction could be achieved through a formal competitive process, in part by better realising scale benefits. By comparison, Rice Warner estimates potential scale benefits in the superannuation sector of 20 basis points over the next four years: Rice Warner 2014, MySuper Fees, Data provided to the Financial System Inquiry, 6 November 2014. The 30 basis point fee reduction has been applied to assets of $1.2 trillion in APRA-regulated funds as at 30 June 2014. Australian Prudential Regulation Authority (APRA) 2014, Quarterly Superannuation Performance (interim edition), June ed., APRA, Sydney, page 8.

45 Modelling prepared for the Financial System Inquiry using Treasury models, October 2014. The models are based on a 30-year-old male worker in 2014 who retires at age 67.

46 National Seniors Australia 2014, Second round submission to the Financial System Inquiry, page 5.

47 For example, as at 30 June 2014, there were six million lost superannuation accounts with a total value of just under $16.8 billion. Australian Taxation Office (ATO) 2014, Lost and ATO-held super overview, ATO, viewed 27 October 2014.

48 Modelling prepared for the Financial System Inquiry using Treasury models, October 2014. Based on assumptions of 37 years of work with an average of 2.5 accounts over a person’s working life, fixed fees of $80 per account and $140 for insurance per account per annum (in 2014 dollars).

49 For example, see Association of Superannuation Funds Australia 2014, First round submission to the Financial System Inquiry, page 31; Australian Institute of Superannuation Trustees 2014, Second round submission to the Financial System Inquiry, page 35; and Equip 2014, Second round submission to the Financial System Inquiry, page 9.

53 A Roy Morgan Research report, based on approximately 30,000 interviews each year with members of superannuation funds, shows rates of switching between superannuation funds in the range of 2 per cent to 5 per cent since 2005. Roy Morgan Research 2013, Superannuation and Wealth Management in AustraliaReport, December 2013, page 29.